Stop-loss orders:

This is an order placed with your broker to sell a security when it reaches a certain price. It’s intent is to avoid significant loss on a declining security. For example, an investor who purchases a stock for $50 per share, may set a stop-loss @ 10% (as an example) below this @ $45. If the stock hits or dips below this figure, the shares will be sold @ market. This strategy has its place in traditional long term investing but, in my view, has limited application for covered call writing.

Complications from using stop-loss orders when selling covered calls:

1- We are in a “covered” or protected position. If the long stock is sold, we still have a short call on the table. Our brokerage will not allow such a scenario UNLESS we have have approval for naked call writing. Most BCIs can not get or even want this approval. It’s actually better for most retail investors NOT to have this approval to avoid accidentally selling the stock and face the immense risk of a naked short call position. Bottom line: in order to close our long stock position, we must first close our short call position (B-T-C).

2- Placing a stop-loss order to close the short option position first and requesting notification if and when this trade is executed. At this point the second leg of unwinding this position, the sale of the stock, can be accomplished. The issue with this approach is to predict the relationship between the option price and the stock value. This is virtually impossible to do because the call premium is dependent on many factors like implied volatility and the type of strike (I-T-M, A-T-M or O-T-M). Therefore, after buying back the option, selling the stock may not be the best action.

3- Placing an OTO (one triggers other) Order:

This is when you instruct your broker to close the entire position by first buying back the short call and then selling the underlying security. The problem here is that many brokers do not permit OTO orders simply because their trading platform software is not programmed to accomodate such trades. Even if brokers do accomodate such contingent trades, we are faced with the same dilemma as in # 2.

4- We may lose an opportunity to generate additional income:

Great performing stocks will sometimes consolidate or “take a breather”, profit-taking if you will. If the stock is still trading above its moving average and no negative news has come out, why not buy back the option and look to “hit a double” and sell the same option a second time. Hastily selling a stock without properly evaluating chart technicals, market tone and current news will cost us money. Stop-losses cannot do this analysis for us. Our brains are required to participate if we want to maximize our profits.

Some say to enter stop-losses when leaving for vacations:

I have a better idea. Purchase a netbook or a laptop for a few hundred dollars and take it with you. You’ll make your money back quickly and the time spent will be minimal. If you want to vacation and not think about the market, close your positions before you leave (or don’t enter them to begin with) and get back in the game when you return.

Now that we know what NOT to do, what SHOULD we do? : 

• The 20%/10% rules for buying back the option and then….
• Hitting a double
• Rolling down
• Closing the entire position

Which choice we select requires our brains and common sense, not our friend Robby the Robot. We evaluate stock technicals, market tone and check for changing equity news. It won’t take much time. When we are ready to act, our decisions will CRUSH those of Robby and we’ll have a lot more cash in our pockets for it.

Conclusion:

Setting stop-loss orders is more appropriate for long-term investing than it is for covered call writing in the eyes of this author. Becoming educated, active and proficient in position management will prove to be both a time-efficient and wealth-enhancing approach to covered call writing. Just like the savvy, experienced pilot guides his jet across the country so should we guide our portfolios to positions of great wealth.

Last Week’s Economic News:

This past week was once again the bearer of mostly positive news. Industrial production rose 0.8% in November, the highest monthly gain since August. New construction of privately owned housing rose 8.9% in November. Despite modest increases in the PPI (Producer Price Index for finished goods) and the CPI (Consumer Price Index), economists stood by their assertion that inflation was under control. The Conference Board’s index of leading economic indicators rose for the eighth consecutive month. The Fed left the target range for the federal funds rate at 0% to 0.25%. This is the rate that banks charge each other. For the week, the S&P 500 dipped slightly for a year-to-date return of 25%.

This Week’s Economic Reports:

• Tuesday: Gross domestic product and existing home sales.
• Wednesday: New home sales and personal income.
• Thursday: Durable goods

A few reminders:

1- All DVD and CD packages ordered over the weekend will be shipped via expedited mail AT NO CHARGE, on Monday morning to assure arrival prior to Christmas.

2- Options symbology will be changing in February. You should be hearing from your brokerages in the near future if you haven’t already. This site will review the new symbology in late January.

3- I will be interviewed LIVE on Jordan Kimmel’s Voice America Business Radio Program on January 14th @ 11:30 AM. I will be providing links to the live broadcast and to replay information as the date approaches.

Video currently playing on the homepage (NEW):

Earnings Reports and Covered Call Writing

Wishing you the happiest of holidays from my family to yours.

Alan and Linda and the BCI Team

alan@thebluecollarinvestor.com

The last two weeks have been CLASSIC for a situation when “hitting a double” exit strategies can be employed in the middle segment of a contract cycle. For those new to covered calls, see chapters 6 and 10 in Exit Strategies for Covered Call Writing and chapter 11 in Cashing in on Covered Calls for a review of this subject. Let’s first take a look at the chart of the S&P 500 over the past 10 trading days:

S&P 500 10-D Chart as of 11-6-09

Note how the chart takes a large dip down and then recovers. Stocks and their corresponding options will be influenced by this market pattern. After we sell an option, if the stock and option premium decline, it may create an opportunity to buy back the option (using the 20/10 rule as a guide). Once we buy-to-close our option position we now own the stock and have an opportunity to re-sell the SAME option if it rebounds as many did this past week. So this is a two-stage process, first we must seize the opportunity to buy back the option at an appropriate time, and then sell that same option if and when the stock and corresponding premium heads back up north.

BCSI:

Here’s a real-life example of such an exit strategy which generated the $868 into my account last week. This by the way, does NOT include the original $992 I “earned” when I sold the option for the first time. First let’s look at the chart of BCSI and note how it mirrors that of the S&P 500:

BCSI as of 11-6-09

Note how this equity took a big plunge and then recovered quickly over the past two weeks (very end of chart). Here are the four prongs of this 1-month investment:

1- 10/26/09- Purchased 1000 shares of BCSI @ $25.35

2- 10/26/09 – Immediately sold the I-T-M, November $25 call for $1.35, generating a profit of $992. I deducted the intrinsic value of $0.35 and commission. Should I be happy and complacent and head for the mall? Not Blue Collar Investors!

3- 10/30/09 – Took advantage of a market dip and re-purchased the 10 contracts for $0.25 (20% rule). This created a loss of $262, including commisssion.

4- 11/5/09 – Took advantage of a market upswing and re-sold the EXACT SAME OPTION for $1.15. This generated an ADDITIONAL $1130 into my account.

$868 in ten minutes is no exaggeration:

It took me less than 5 minutes to buy back the option and less than 5 minutes to re-sell the option a few days later. $1130 – $262 = $868. Now if that doesn’t put a smile on your face, let’s add in the initial option profit of $992 for a total profit of $1860. Our original investment was $25,000 (using the intrinsic value of the first option premium to “buy down” the cost of the stock from $25.35 to $25 (use the ESOC calculator if this part troubles you). Our profit thus far is: $1860/$25,000 = 7.4%, 1-month return. So now it’s time to head to the mall, right? Nope, still two more weeks until expiration Friday!

Who else does Alan discuss covered call options with? Click the link below to find out and then the back arrow to return to this article:

mystery-guest

Yep, that’s him and me. Forgive me for that, just couldn’t resist (really just giving him some baseball tips). The 2009 New York Yankees….World Series Champions!

Last Week’s Economic News:

The jobless rate reached 10.2% in October, the highest level since 1983. I found it encouraging that the market ended up for the day despite breaking the 10% psychological barrier. On Wednesday the Fed announced that it will keep its target rate for fed-funds in the 0%-0.25% range “for an extended period.” Construction spending is on the rise perhaps indicating that homebuilder confidence is strengthening. Other positive reports included increases in manufacturing and factory orders as well as a spike in productivity. On the negative side, consumer credit continued to fall as the decline in the jobs market keeps consumers from taking on more debt. For the week, the S&P 500 was up 3.2% for a year-to-date return of 21%.

Upcoming reports that may impact your stock prices (new feature):

As it happens, there are few reports due out this week.

Friday: Update on international trade.

Video now playing on the homepage:

Selecting the Best Strike Prices

Wishing you many future doubles,

Alan (alan@thebluecollarinvestor.com)

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